UK: FCA Restrictions: I Should(n’t) CoCo…

When, in years to come, the academics and economists look back
on the current recession, there will undoubtedly be common factors
that will draw the interest – the rise of sub-prime markets,
the fall of Lehman Brothers, the bankruptcies of entire cities in
the United States. For those operating in the financial services
arena, however, we think that it is the rise of the regulator, on
the back of public and governmental outrage at the behaviour of the
financial institutions blamed for the crisis, which will resonate
most strongly. Given a remit of "never again", regulators
across the world have sat up, gripped their freshly-bestowed powers
firmly, and waded into battle.

These newly aggressive regulators have already left many
casualties in their wake, and, later this year, when the UK's
Financial Conduct Authority ("FCA") will for the first
time utilise its product intervention powers, contingent
convertible instruments ("CoCos") will be added to the
roster of the fallen.

What are CoCos?

CoCos are hybrid capital securities which feature both debt and
equity elements. Issued as a bond paying a coupon, they convert
into an equity security when a certain trigger event occurs. This
trigger point is normally linked to the issuer's regulatory
capital ratio. CoCos were originally designed for purchase by
institutional investors, principally asset managers and banks and
their popularity has increased dramatically in recent years given
the high yields offered.

The FCA has reported that the value of CoCos issued between 2009
and 2013 is estimated to have reached GBP 40 billion (USD 70
billion), 20.7% of which was issued by UK banks. Indeed, Bank of
America Merrill Lynch predicts that the market value for European
Additional Tier 1 capital CoCos could exceed EUR 150 billion by
2020.

With expected rapid short-term growth in issuance, the FCA has
decided to implement measures to mitigate the potential harm caused
to investors by CoCos' complex and unusual characteristics, and
in October 2014, it will restrict the distribution of CoCos to
retail investors.

Risky business?

While financial institutions continue to increase their issuance
of CoCos to fulfill prudential capital requirements, the FCA fears
that their proliferation, and the returns offered, could see the
investor market expand to incorporate ordinary retail investors.
This is particularly likely at a time such as this of low interest
rates when inexperienced and unsophisticated investors are tempted
by high headline returns.

The FCA set out its principal concerns over CoCos in August
2014. Essentially, the fear is that the risks and unpredictability
of CoCos renders them unsuitable for the mass retail market. For
example:

One particular class of CoCos, called "Additional Tier
1", features an equity conversion or writing-down trigger,
which corresponds to the capital position of the issuer. Should an
issuer's capital position fall to a certain trigger point, the
issuer has the ability to write-off (partially or entirely), or
convert into equity, the instrument, meaning that some investors
could be left with little or no return

Additional Tier 1 CoCos also feature entirely discretionary
coupon payments, meaning that they could be cancelled indefinitely
at any point and for any reason

CoCos are also particularly difficult to price, and the
factoring of risks into their valuation can be complex – for
higher-rated instruments, although some characteristics, such as
trigger levels and the credit spread of an issuer, are reasonably
transparent, others, including an issuer's future capital
position and the likelihood of coupon payments, are more difficult
to predict, and at the sub-investment grade, CoCos are even more
difficult to value

The FCA's announcement coincided with a statement from the
European Securities and Markets Authority on the risks associated
with CoCos.

FCA's product intervention powers

The Financial Services Act 2012 introduced amendments to the
Financial Services and Markets Act 2000 ("FSMA") which,
from 1 April 2013, have provided a framework of product
intervention powers available to the FCA, including the ability to
make temporary product intervention rules relating to certain types
of investment and concerning specific persons. The FCA can
intervene if it identifies products that could cause detriment to
consumers either because of their characteristics or issuer
distribution strategies. Intervention effectively prohibits firms
from carrying out certain activities, for example entering into
specified agreements with any person.

Temporary restriction of CoCos

As mentioned above, from 1 October 2014, the FCA will impose one
of these temporary restrictions in relation to CoCos'. The
restriction, set out in the "Temporary Marketing
Restriction (Contingent Convertible Securities) Instrument
2014", imposes a 12 month prohibition on firms selling or
otherwise doing anything that would result in retail investors
buying or holding a beneficial interest in CoCos. The restriction
does not apply to professional or institutional clients or to
exempt persons, and there are exceptions for some activities
– for example, MiFID business relating to the sale (but not
the promotion) of CoCos will be permitted.

Whilst the temporary restriction is in place, the FCA will carry
out a consultation on CoCos, and a policy paper is expected in the
second quarter of 2015, which, it is anticipated, will set out the
permanent rules which will come into force on lapse of the
temporary restriction on 1 October 2015. Given the increasingly
aggressive stance of all regulators, not just the FCA, we consider
it likely that the permanent rules will, at least, mirror the
temporary restrictions. In any event, we shall report again
following publication of the policy paper.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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